Fructivore Investments

I may be in the minority among the financial community and the public, but I do not assign any mystical economic or investing qualities to China or any of the companies in it. There was a similar hysteria in the 80s over Japan, and we all recall how that ended. I find it similarly unlikely that China has discovered how to repeal the ordinary rules of economics. Furthermore, although I have no direct proof of it, I suspect that the astounding growth figures in China are exaggerated, considering that they are still reporting high GDP growth in the face of articles from earlier this year about exports dropping and migrant laborers going home.

However, these sentiments should certainly not disqualify a Chinese company from consideration for investment; Warren Buffett (and presumably other investors as well) noticed that South Korea sits in the shadow of North Korea’s missiles and its accounting rules make Japan’s look like a model of transparency. This resulted in a number of stocks drifting around to a P/E ratio of 3. But, with careful analysis, it became clear that among the mess a few of those stocks were legitimately offering those kinds of P/E ratios.

American Lorain (ALN on the Amex), sadly, doesn’t have a P/E ratio of 3. But it is 5.26 as of this writing, which is not bad. It is an American-registered firm that, through a multi-tiered capital structure, owns four operating subsidiaries in China, one of which is shared 80:20 with the Chinese government. They produce a wide variety of chestnut products and other processed foods in a number of markets, primarily China, but including the rest of East Asia and various other nations. Although they claim to control various proprietary technologies including a method for permeating a chestnut with syrup without altering its texture, I don’t believe that they are blessed with any sort of durable competitive advantage, although they claim to be the largest chestnut processor in China. Operations-wise, they seem to be fairly dependent on bank debt, and based on their SEC filings short-term interest rates in China are surprisingly high; between 5 and 10% for their various short-term borrowings, which they have expanded considerably in anticipation of the third and fourth quarters when they see their highest demand. Their balance sheet does also count more than $2 million worth of “landscaping, plant and tree” as an asset, which seems like kind of a stretch.

The company also does not have a long operating history, having only been in operation in its current form for a couple of years since its effective IPO and having only been listed on an exchange since last September, although the actual business has been in operation since 1994. They have also had issues with getting their SEC filings in on time.

At any rate, if any of you have an appetite for investing in China, American Lorain is a suitable candidate; it is a firm in a relatively stable industry, with reasonable growth potential, that is manifestly underpriced both in terms of P/E ratio and return on equity, even without consideration of any supposed China premium. I don’t necessarily believe in international equity and currency exposure just for the sake of having the exposure, but international underpriced exposure is a different matter entirely.

Warren Buffett once wrote that in financial analysis, having an IQ above 125 is wasted and that success in investing is largely a matter of temperament. This tells us two things, one, that the world’s greatest investor thinks that dispassionate adherence to investing principles is more important than fancy quantitative models, and two, that Warren Buffett’s IQ is 126.

The most dispassionate method is the “net-nets” recommended by Ben Graham. These are firms whose working capital (cash and short term investments, receivables, and inventory) exceeds their total debts, and which are selling to a discount even to that. In other words, the current assets of the firm will pay for the purchase of the entire firm, and the firm’s longer-term assets and the future earning power they represent are available for free, or in fact, the current shareholders are paying you to buy them. The Snowball, Warren Buffett’s biography speaks of Benjamin Graham’s employees wearing lab coats and filling out forms to calculate whether a net-net existed. Nowadays, with SEC filings available online and the Excel spreadsheet having been invented, one would expect that these opportunities are harder to find, and indeed they are, and upon seeing them one might be curious as to why.

In theory, a diverse portfolio of these investments could be purchased without any further analysis, but as I’ve stated there may be something other than a depressed market at work. USEC Inc., for example, sold at less than its net working capital for a long period, but it was actually stockpiling cash in order to build its centrifuge plant, and we all know how that worked out.

Anyway, some kind person on the Internet has a screener to identify these opportunities. Most of them are over the counter or penny stocks, which are difficult to trade and subject to liquidity issues, which does suggest that neglect by the market is still a significant cause of these net-nets appearing. Some of them are in danger of delisting, which in theory does nothing to a firm’s operations, but usually does adversely affect its share price and also its access to capital markets. More troubling than trading difficulties, though, are operational difficulties; if the firm has a negative operating cash flow, it is quite conceivable that it will burn through the discount it sells for, thus robbing these issues of their apparent safety. Another issue is firms that reclassify their long-term investments to short-term, as with Asta Funding, a debt recycler on the list, has reclassified all of its portfolio of debts as receivables, when in reality they hold the debts for multiple years. Other firms may have inventories that need writing down.

But a firm that can avoid these troubles is almost by definition an attractive investment. Key Tronic Corporation (KTCC), manufactures circuit boards and other electronics. They have positive operating earnings, although they are a bit low in terms of return on capital, but more importantly they have 61 million in current assets, 27 million in debts, and 24 million in market cap, leaving a discount to current assets of $10 million, producing a 42% discount which makes a very decent margin of safety. Hence, this firm is worth more liquidated than it is valued at as a going concern, and when the economy improves and they have more orders, their return on assets should dramatically improve.

So, clearly fine returns can be made off what the market overlooks, if you do a little homework to make sure the market isn’t actually right.

Damodaran on Valuation claims that unnecessary financial assets, such as stocks or bonds or other securities of other corporations, have no effect on a company’s valuation, since the risk-adjusted discounted cash flow they produce is equal to their present value, so there is no incremental benefit to owning them or decremental drawback from getting rid of them. Of course, this position assumes that markets are efficient which is at odds with both the central theory of value investing and presumably Damodaran’s own purposes in writing, since he did call his book Damodaran on Valuation, rather than Damodaran on Giving up and Becoming an Actuary.

However, he does raise a good point; why should the shareholder pay management fees and submit to double taxation for a firm to hold financial assets that the shareholder could just go out and buy if the company had just issued a dividend instead of paying for the assets? The only possible explanation is that the firm is in fact capable of producing better investment results than the majority of its shareholders. Damodaran cites Berkshire Hathaway as a rare example of this firm; most corporate managers who are not Warren Buffett realize that investing in securities to produce above-average returns is difficult to do well and indefensible if done badly. Just ask any failed investment bank.

So, what do we do with a firm that does not seem to be aware of this principle? Specifically, CCA Industries Inc. (CAW), a tiny firm that makes low-end toothpaste and beauty products, reports that of its approximately $33.5 million in assets, $14.5 million are short-term investments or marketable securities. Year to date income produced by these investments has been $212 thousand, resulting in an annualized return of a bit under 3% as of the May 31 reporting period. However, for their actual operations, the other $19 million in assets has produced pretax earnings of $1.29 million, which is a return on assets of 13.6% if it is doubled to fill out the year. (And this assumes that all the cash on their balance sheet is needed for their operations). So, it is pretty apparent that the financial assets they hold are superfluous. In fact, if they did distribute all of their excessive assets, the market cap, currently 29.5 million, would drop to 15 million, which would be amply supported by $1.7 million in after-tax earnings (apart from accounts payable they have virtually no debt to speak of).

This being the case, how has CCA gone this long without some enterprising investor raiding it? According to the writeup at the Value Investor’s Club, it is because the firm is controlled by two old men in their 70s. There was a deal proposed last year to take the firm private, but it fell through. Otherwise, the stock seems to be entirely under Wall Street’s radar.

If Damodaran is correct, and the unnecessary financial securities do not produce any actual value to the company, then buyers of this company are in fact buying $19 million in actual capital, $2.6 million in operating earnings, and $14.5 million of excessive holdings taunting them. Unfortunately, as long as the two old men control the company there is no realistic way to force the distribution of the excessive assets, and in the meantime the firm’s aggregate return on capital will be suboptimal, resulting in a depressed share price. We hope for the sake of the noncontrolling shareholders that the company’s owners will listen to reason.

P.S. They pay a 6.7% dividend, although the dividend history has been somewhat erratic.

Edit: The firm just announced earnings, but without the concrete detail that breaks down operating versus investing earnings. When I have those, I will do an update.  I don’t expect too much to change in my analysis, though.

Update:  Their interest and dividend income is up to 245 thousand year to date, producing a return on capital investments of 2.3% on an annualized basis (although they also have some capital gains which pushes the total to 2.8%). Their return on assets from their actual operations is 14.0% pretax. QED.

Those of you who watch Jim Cramer, of whom Seth Klarman said that he is a symptom of everything that is wrong with the financial world nowadays, will recall that last week he expressed approval of the safety of Windstream’s dividend. He also mentioned Fairpoint Communications (FRP), after qualifying his remarks with the fact that they have little in common apart from them both being rural telecom companies—their financial positions are completely the opposite. Fairpoint Communications has recently announced that they are defaulting on their credit facility, and that their larger creditors have agreed not to force them into bankruptcy until the 30^th.

Fairpoint recently acquired Verizon’s land lines in New England for $2.3 billion, which it turns out was a few hundred million too much, thus demonstrating the value investing principle that there are no good or bad investments, only good or bad prices. After all, anything can be at least liquidated, and with a bankruptcy in the works that is looking like a distinct possibility. Since that time, declining revenues have sunk their income, causing them to suspend their dividends in 2008 and now, it seems, to suspend their interest payments as well.

According to rumors, Windstream is a potential buyer of Fairpoint’s distressed debt, alongside several players in distressed debt. This is perfectly reasonable; inside or outside of bankruptcy, the creditors take the assets of the defaulted debtor, and Windstream certainly could do more with the assets than a distressed debt fund on Wall Street. If they acquire a powerful position in Fairpoint’s distressed debt, this will give them a suitable platform in the Chapter 11 negotiations to arrange transfer of some or all of Fairpoint’s assets to them. It is not unusual in a bankruptcy to create a situation where there will be cash and securities in the reorganized corporation available, with creditors able to choose between the two of them. So, Windstream would perhaps be able to take more securities and less cash. And, since the market for distressed debt tends to be illiquid and the valuations necessarily conservative and more geared to liquidation rather than going-concern values, distressed investing generally produces high returns to go along with the analytical and legal work involved.

Even outside an actual Chapter 11, bankruptcy is still a specter that hovers over the entire process of negotiating a debt workout. Such a workout still results in selling off profitable divisions and arranging debt-to-equity conversions to provide partial relief to satisfy creditors. Just look at AIG. In fact, in a significant proportion of bankruptcy cases, the debtor has already acquired a sufficient number of votes from the creditors of each voting class, thus making the actual bankruptcy process largely a formality, as with GM’s. So, inside or out of formal bankruptcy, Windstream has the same angle.

I should point out, though, that in the last reported quarter, high speed subscribers in the regions Fairpoint purchased from Verizon declined by 3.3%. The company attributes much of this to “cutover related issues;” in other words, they were too busy integrating their systems after the merger to actually sell their products. This is understandable, but since Windstream and every other telephone company is trying to combat loss of land lines by expanding their premium services, this is disturbing news. Their operating income, although it exists (positive operating income now or eventually is a minimum requirement for saving a company with bankruptcy as opposed to killing it), is very low, just a hair over 1% return on assets, so hopefully there is room for improvement.

Obviously, it is too early to say anything, and the rumor of Windstream even buying the debt has not been confirmed, but since Windstream has embarked on two opportunistic acquisitions already in the last year, it would be a positive development for them to be feasting on Fairpoint’s corpse alongside the other vultures. As for ourselves, we like low-hanging fruit and have no objection if some fruit gets blown off the branch by a strong economic headwind. So, if the rumor is true this is another positive for Windstream, although they might want to recall that acquiring more than they can chew is what killed Fairpoint to begin with.

And if you’re wondering about the Star Trek picture, I kept typing “Farpoint” instead of “Fairpoint,” and I couldn’t find an image that suggests a bankrupt phone company anyway.

Some of you may recognize our old friend the yield hog from the Windstream article, but we should ask ourselves what a dividend signifies. For bonds, yields are typically all we get, but for stocks? True, a big dividend yield will amortize our margin balance if we choose to buy on margin, but as Seth Klarman puts it, margin is unnecessary for the value investor, and indeed is often counterproductive.

But, if the firm does not distribute its free cash flow in the form of dividends or some other way, that money is still sitting inside the firm and still belongs to the shareholders. Of course, Ben Graham’s quick and dirty valuation formula valued dividends at three times undistributed earnings, but in his day dividends were viewed as an integral part of the return from equity investment, whereas now they are viewed as a distraction from the corporation’s management trying to build their empire.

In theory a corporation should only hang onto its excess cash if they can produce higher returns by keeping it than its shareholders can produce by receiving it and investing it themselves. Cash has fairly low returns, so building up cash just to keep it built up on the balance sheet should be viewed as robbing the shareholders. Benjamin Graham actually tried to engineer a hostile takeover to get a firm to disgorge its unnecessary investment holdings.

Breitburn Energy Partners LP (BBEP) suspended its dividend last year on the grounds of enhancing liquidity, and predictably the price of the shares tanked. As with Linn Energy, apparently Breitburn was viewed a dividend factory rather than a corporate empire type. But, also like Linn Energy, it seems to be a convincing one. In fact, they have adopted the same hedging strategy running for years into the future, so a buyer is betting on their competence as a natural gas and oil producer rather than on the movements of oil and gas prices. Using the technique of doubling current earnings they will earn $200 million this fiscal year, giving the company a P/E ratio of 2.5, or 5 based on last year’s pre-tax full year earnings. They have been increasing the pace of their operations, though. In fact, if Breitburn had not eliminated its dividend they would be yielding almost 20% at current prices. Now, rather than piling up their cash, they are paying down debt (ironically, piling up cash would be the most liquidity-enhancing move of all). Going by their books, they have cut their liabilities considerably since they started preserving money. However, the interest rate they pay currently is about a fourth what their cost of equity is as determined by their PE ratio so if they wanted to fix cost of capital instead of liquidity they are going about it the wrong way.

So, if you liked a productive, hedged producer like LINN, and are willing to forego a dividend until Breitburn’s managers decide that they are sufficiently liquid, Breitburn should be the ideal stock.

According to the news, the FDIC’s insurance fund is in danger of being totally drained. The article’s author speaks of several strategies that can be used to shore it up, which is borrowing money from banks, from the government, or by levying a special fee on banks. The article portrays all of these as risky and unnatural options. Borrowing money from banks that can afford to lend it is called a bad idea because it diverts money from the private sector. Borrowing money from the government is bad because it looks like another bailout. And raising the money by a special bank fee weakens banks that cannot afford to be weakened right now.

As to borrowing the money from healthy banks, any effect on the private sector from removing the money would be dwarfed by the fallout from the massive bank run if an investor actually suffered a loss due to the bankruptcy of the FDIC. Of course, since the bankruptcy of the FDIC fund is not seriously an option this is not going to occur. However, it seems to be unreasonable for the FDIC to have to pay interest to one bank on behalf of the depositors of another. Using the Treasury’s line of credit would make more sense, although it does look like another bailout to the banking industry, and banks themselves are not looking forward to higher fees down the road to repay interest and principal.

Of course, these would be the banks that are the problem in the first place, and who do not seem to be aware of the concept of insurance. Obviously, a sound system of insurance requires risk-based pricing, so as risks go up an insurance company has to increase its premiums accordingly in order to remain solvent. And it seems to me that if a bank cannot handle an occasional disruptive, unforeseen expense like this, it would be better off in receivership. After all, there are plenty of wealthy banks that are capable of taking them on.

Great Southern Bancorp (GSBC) for example, has taken on two failed banks this year. Although the economic situation has impacted their results they have been able to squeeze out some profits, and on the whole I believe them to be in an excellent financial condition. However, I’m not exactly pleased about their handling of loan loss reserves. Capital One deals with reserves in the aggregate, which, considering their size, they have to do. As recently as 3^rd quarter 2008, GSBC reported non-performing commercial loans singly, as befits a small town bank. However, since their transfers to loan losses normally run only a few million per quarter, a cluster of bad loans can produce a huge mess in unforeseen expense. In 1^st quarter 2008, they lost a great deal of money (for them) by loaning a large sum to bail out a fellow bank that subsequently went under, and not very much later they lost another small fortune on Fannie and Freddie preferred stock. Since these experiences they seem to have learned to wait until after the receivership/bailout to commit capital to banks. If their earnings return to normal they would have a P/E ratio of 10 or 11 which is suitable for a normal bank, although the TARP money they accepted forbids them from raising their dividend.

So, if you want a bank, rather than gamble on the recovery of an unwieldy large bank that needs the special attention of the Treasury, consider a small one that is busy eating smaller ones.

As you may recall, I commented on the dangers of being a yield hog, which is a constant temptation for those of us who seek investments that produce high and sustainable cash flows. Sustainable but not high is not good enough, and high but not sustainable is even worse, because when the cash flow runs out all the other yield hogs will dump the security in question, depressing its price even below fair value. Not surprisingly, just running a stock screener to rank all stocks by yield is inadequate, but it nonetheless can produce candidates that are worthy of further investigation.

Calumet Specialty Products (CLMT) is an investment partnership that produces various petroleum products. It currently pays a dividend of 12.3%, and has a P/E ratio of 10.68, so it is almost covered. However, their earnings seem to have been fairly variable over the years and sales have been dropping from their heights, so this is probably not a good source of sustainable cash flow, although their dividends have been covered by operating cash flow, if not net earnings, for three of the last four quarters.

However, you wouldn’t deduce any of the dividend coverage issues from the partnership agreement. Unlike investing in stocks, where the status of the shareholder is tolerably well known, in partnerships the terms of the partnership agreement must be considered individually before investing. Like LINE’s agreement, they are required to distribute all available cash. However, Calumet’s agreement further requires the distribution of 45 cents per partnership unit every quarter, subject to their credit limit. Furthermore, as the available cash exceeds 45 cents, the general partner takes a larger and larger share of the distribution, from 2% for 49 and a half cents up to 50% of the marginal cash when the distribution exceeds 67 and a half cents. So, where corporate managers are often accused of keeping dividends too low in order to expand the size of their empire, the general partner here could potentially be accused of deliberately starving the company by increasing its own incentive distributions. Of course, there are rules as to what is “available cash,” but there has to be some discretion available.

At any rate, a policy that requires the payment of dividends even when the cash is not earned and has to be borrowed is generally a recipe for disaster. In the 80s companies borrowed money and distributed it to shareholders in an attempt to frighten off the takeover artists, which was a questionable strategic move, but Calumet’s policy isn’t even strategic. It puts them dependent on raising additional capital, either from their lenders or from the public (they did make new offerings of equity in 2007 and 2006). And, since they are under an obligation to pay the 45 cents to the new equity as well, the possibility of a Madoff-like ending (although fraud would not be involved) cannot be ignored. As Benjamin Graham stated in response to a Supreme Court ruling denying relief to holders of preferred stock with noncumulative dividends, it is only what the parties agreed to, and a court cannot just rewrite a contract.

So, if you are looking for a high and sustainable dividend, I suggest looking elsewhere for the moment. Given the number of potential investments out there, compromising our standards of safety for a specific one is unwise.

I suppose the ideal solution for me would be to align this blog with a subscription newsletter. Telling you what to buy would be free, but telling you when to sell would cost you. Since that strikes me as a little mercenary, I’m telling you all that I’m out of CMO.

If you’ll recall, I recommended CMO because the low interest rates have produced a huge financing spread for their mortgage portfolio, and I did warn that if interest rates went up, CMO’s dividend would lag. Although interest rates presently show hardly any signs of going up, what has gone up is CMO’s price; it hit 14.60 today. The company’s book value per share is in the neighborhood of $11.50, and the face value of their debt per share is about $3.50 lower. Although the mortgages are probably entitled to a premium over face value while trading because of the government explicitly guaranteeing them,  interest is paid on the face value, and principal repayments are also made at face value.

Now, interest rates are going to rise eventually, and when that happens CMO’s fat dividend will diminish, or depending on the speed of the rate change, may even disappear, at which point the yield-hungry investors will look elsewhere, collapsing the price back down to book value or even face value. At any rate, the dividends that CMO is likely to generate until then are probably equal to or exceeded by the current premium over book value, so there is no real purpose in holding on any longer to collect a dividend that is already priced in.

Benjamin Graham wrote in Security Analysis that a great deal of financial analysis involves recasting financial reports to get a full sense of a firm’s baseline ability to produce earnings. A lot of the process involves removing nonrecurring or irrelevant events from a single year’s results, as we did with LINE’s profits on its derivatives. Over a longer period of analysis, like five or ten years, we leave the nonrecurring events in or perhaps even distribute them on average over the period. Nonrecurring events still tell us how unlucky or unskilled management is over time, and even though for a single year’s earnings we may forgive a large nonrecurring writeoff all at once, a writeoff is still money gone, and there is a limit to forgiveness.

Much of this fiddling with nonrecurrent events is the fault of accounting rules anyway. When it comes to goodwill, writeoffs take on an unusual character. Goodwill represents the purchase price paid to acquire a company that is in excess of the assets of that company. It represents the excess returns available from buying an established company instead of just replicating it, or, if you believe Damodaran, some of it comes from the “growth assets” of a company – the assets it will one day acquire to produce its growth and future excess returns. A lot of analysts advocate ignoring goodwill entirely, when it first shows up as an asset and when it is inevitably written down when conditions deteriorate. After all, if there are excess returns in a business they will show up in the income statement anyway, so counting both the excess returns and the goodwill looks like double counting. Goodwill nowadays, instead of being linearly written down over time, is now written down whenever, in the opinion of accountants, the excess returns it generated are no longer there. Since this essentially trades one accounting fiction for another, I can’t say that it’s solved the problem of dealing with intangibles, but it does make the data more frequently subject to large, discrete abnormalities.

ConocoPhillips (COP) is an integrated oil producer and refiner that wrote down $25 billion of goodwill last year, plus more than $7 billion for their interest in a joint venture, on the grounds that with the price of oil and the economy down, returns on their business and its recent acquisitions are going to suffer. With our policy of ignoring goodwill, we might say that without the writedowns they earned $15 billion last year, and earned $12 billion the year before that and $15 ½ the year before that. And since the market cap is less than $70 billion, even looking at the worst case their PE ratio was less than 6.

However, as I’ve stated, goodwill writeoffs have to go somewhere, or to be precise they have to come somewhere since the company paid for that goodwill. This year, earnings have been running far behind what the previous years’ performance suggests they would have been, only $2 billion in the first two quarters when last year they were $9 ½. I should point out that unlike Linn Energy in the last post, COP does not hedge its commodity exposure , which is understandable because COP’s production is orders of magnitude larger and the integrated nature of its  business theoretically leaves them less exposed to price changes, as with Rayonier.

We can reconcile the irrelevance of goodwill with the fact that the company has run into a wall by considering return on equity, since equity is where goodwill writeoffs come from. If we double this year’s earnings, and divide it by the book value of equity at the end of last year, we get 7.8%, which looks pretty reasonable, although since COP trades at a moderate premium to book value that is not the return on a purchase at this price. If we put the writeoffs back in and look at last year’s return on equity, though, we get 16.9%. The year before, 13.6%, and the year before that, 19.1%. So, although the goodwill writeoff made more sense than leaving the goodwill in, it hasn’t accomplished what the rules intended it to, which was reconciling earnings power with asset values.

I’m not sure how much of this is temporary and can be blamed on the recession, but it seems simplistic to me that goodwill can always be ignored. Since it represents extra money paid for an acquisition, and since its being written off represents overpayment, I think the more conservative solution is only to look at it in a negative fashion; not counting it as an asset but definitely counting it as a writeoff, at least for a multi-year analysis. And if COP is representative, jumping in after a big writeoff is dangerous. And identifying where the low-hanging fruit isn’t is just as important as identifying where it is.

A stock screener is a useful toy for an investor. In most markets bargains cannot be found by checking stocks at random, and a good screen is a good way to narrow the field. However, a screen is only a first step; a poster at a forum I visit (the same one who referred me to Linn Energy, actually) complained that the first thing new investors do once they finish a copy of Graham’s The Intelligent Investor is run a screen for stocks with a PE ratio under 10, pick out a few names they recognize, and that is their portfolio. There is a certain logic in this plan, since the annual return from the market indexes is said to have been between 9 and 11% depending on who you ask, and without projecting growth a PE ratio of 10 at least gets you what you pay for. And a PE ratio significantly less than 10 looks very appetizing.

However, the trouble with screeners is that they can produce some perfectly ridiculous results. For example, Linn Energy LLP (LINE) has a PE ratio of 1.39 right now. Obviously, this means that you can buy it and get your money back within a year and a half, and still own the stock, right? Well, although the value investor acts under the theory that the market occasionally gets things wrong, rare is the occasion indeed when it gets things crazy (although it does happen). It’s much more likely that the “real” P/E ratio is different. And yet, with a yield of over 11%, LINE is worth a second look. Just because the data make no sense doesn’t mean that the market can’t still be wrong.

LINE is an oil and gas producer, and the bizarre PE ratio comes from the fact that, like many producers, they use derivatives to hedge their exposure to the price of oil and natural gas. However, accounting rules require them to record the changes in value of their derivatives during each earnings period, but they are not permitted to record the counterbalancing change in the oil and gas they hold. Since LINE holds three to five years’ worth of production of these derivatives, any hiccup in the price of oil or natural gas will affect those derivatives by several times what their current results will be affected by. So, ironically, the derivatives that are supposed to make their operations more stable make their reported earnings quite unstable.

In 2008, if you remove the unrealized portion of the derivative gains from their results, their income from operations drops from $825 million to $141 million (much of this income appeared in the most recent two quarters, hence the bizarre PE ratio).  This is an issue considering they paid out $287 million in distributions in that year. YTD 2009, removing the unrealized losses moves their results from a $147 million loss to a $138 million income from continuing operations, and they distributed $145 million to date. The terms of the partnership require them to distribute all excess cash, hence the high payout ratio. At least for the last six months depreciation has equalled cash spent on investing activities, and before then they were still in the capital-raising phase, which clouds the picture.

I don’t know that I see much capacity for near-term growth; virtually all of their projected production is hedged at prices well above current prices; about $7.50-8.50 for natural gas when the current price is less than $5. For oil, half of it is locked in at $90/barrel, or higher. Because of the collars and locked in prices, they don’t benefit if prices go up, just as they’ve avoided suffering as prices have come down. And if they develop a new field, they’d have to lock in the current prices, not the historical ones they had when prices were higher.

What concerns me, though, is stability of operations. WIN, our other high yield candidate, has a long history of producing enough cash flow to cover their distributions, while LINE doesn’t have a long history at all. Even adjusting for derivatives, I’m not sure that its earnings will be stable at this level; utilities have a reputation for stable operations and LINE claims to develop long-lived fields, but that doesn’t tell us how they will do once they have to reset their hedges. If they do keep their earnings stable, for 2008 earnings as adjusted by me they’d have a PE ratio of 18.23, and for doubling 2009 YTD earnings, 9.31, which is not bad. It’s an earnings yield of 10.74% which would almost cover their dividend, and if their depreciation and amortization are not commensurate with future capital costs the dividend may well be covered. Normally one would want to see higher dividend coverage so the company doesn’t have to sell debt or equity to keep up the dividend, and indeed LINE has been raising additional capital by selling new partnership units, which would be unnecessary if they would drop the policy of distributing all available cash. So, if you think they’re going to be stable at this level, they probably would be worth considering for investment. But their PE ratio is certainly not 1.39.